Pet Peeves: Monetary Policy Edition

A few critics of quantitative easing (QE) and the zero interest rate (ZIRP) have correctly pointed out that these policies weaken the dollar and thereby reduce the purchasing power of American paychecks. They increase the risk of future inflation, obscure the true cost of the unsustainable fiscal policy the federal government is running, and transfer wealth from savers to debtors.

But QE and ZIRP also reduce long-term economic growth by punishing savers, reducing saving and investment over the long run. They encourage the misallocation of resources that at a minimum is preventing the natural rebalancing of our economy and could sow the seeds of another painful boom-bust.

There is a lot going on in these statements. Also, I don’t like thinking about monetary policy in terms of interest rates. Nonetheless, here are my main points of rebuttal:

(a) Does the Fed control real interest rates in the long run? In other words, the author seems to think that by having the Fed target a federal funds rate near zero that this effects savings and investment (i.e. lower interest rates lead to lower savings and since savings=investment this means lower investment and lower growth). But don’t people make savings and investment decisions based on real interest rates whereas the Fed is targeting a nominal interest rate? Consider an example to illustrate my point. Suppose that the Fed came out tomorrow and said that they wanted to promote savings and investment and therefore were raising their target of the federal funds to 5%. Holding inflation expectations constant, the Fisher equation implies that the real interest rate would rise substantially. However, we cannot hold inflation expectations constant in this example because that policy would necessarily have an effect on inflation expectations. In fact, it is very likely that this policy would induce expectations of deflation. The policy would do nothing to raise real interest rates.

(b) The use of “boom-bust” is clearly a reference to the Wicksell-Hayek business cycle model. However, in that model the boom (which leads to a subsequent bust) is caused by malinvestment due to the fact that the market rate of interest is set below the natural rate of interest. Assuming that this view is empirically valide, what is the current natural rate of interest? One empirically testable hypothesis from this view is that when the market rate of interest is held below the natural interest rate, this results in ever-accelerating inflation. Do we observe ever-accelerating inflation? Do we at least observe rapidly growing productivity in the face of stable inflation? I think that the answer to those questions is no.

(c) Does inflation reduce the purchasing power of American paychecks? First, this depends on how we measure things and the time horizon. If American paychecks have less purchasing power, then we would expect to see real compensation declining. We don’t. Perhaps the author is referring to the purchasing power relative to other currencies. Have we seen a marked depreciation in the USD relative to the Euro or the Pound sterling? No.

Do not mistake this analysis for downplaying the costs of inflation. The costs associated with inflation can be significant. However, just because something costs more in nominal or real terms does not necessarily mean that individuals are worse off. For example, we have seen a large increase in the price level since 1970. Nevertheless, given that an 18 cubic foot refrigerator cost about $400 in 1971 and the same size refrigerator costs about $450 today, the average worker in 1971 would have had to work about 107 hours to purchase that refrigerator (based on average wages) whereas the worker in 2011 would only have had to work about 23 hours.

Rising prices aren’t a cost of inflation, they are the definition of inflation.

(The costs of inflation are the things that would have been avoided in the absence of inflation. For example, the inflation tax on money holdings, “shoe leather” costs, costs associated with shorter contract durations and negotiation, etc. Read Axel Leijonhufvud, for example.)

(d) Inflation reallocates wealth from savers to borrowers only when it is unexpected. Has inflation been higher than expected?

7 responses to “Pet Peeves: Monetary Policy Edition”

Does the central bank of Argentina/Russia control the interest rates in the long run? Certainly not. Except that, when the correction presents itself dressed as a bubble bust, or (worst case scenario) as a currency flight, nobody’s happy. Does FED?

>> Inflation reallocates wealth from savers to borrowers only when it is unexpected.

You can’t be more wrong. But you can try. Inflation as dilution of purchasing power of a nominal currency unit (price inflation) may manifest itself with a lag. Inflation as issuance of nominal units of currency (money inflation) inevitably redistributes wealth.

>>Inflation as dilution of purchasing power of a nominal currency unit (price inflation) may manifest itself with a lag

You cannot agree with this and also with EMH (or really anything resembling EMH). I’m not sure what your proposed mechanism is and you don’t explain it. You presumably have a model of market actors that does not assume rationality? I think you need to state your model and give the reason why it leads to your conclusion.

Expected inflation distributes wealth away from people who hoard cash, but because it is *expected*, the cash hoarders know this and choose to hoard cash anyway. That’s not ‘redistribution’ in the normal sense of the word since it is voluntary. Again if there is some other mechanism at work here it’s not obvious so you have to state it.

Which EMH? The weak one, basically asserts that _markets cannot beat markets_. No quarrel here. The strong one (prices reflect all existing information) requires some extraordinary belief from its followers. I’ll pass. And anyway, now I see that I mis-expressed myself. I was speaking about the… “price inflation follow money inflation with a lag”

Right. And wrong. Inflation expected or otherwise distributes wealth away from anyone whose income grows slower than the effective inflation, which is pretty much anyone whose negotiating power is below average. Also someone has to be the first to spend the created “delta”. Hint: those are not the losers.

One more remark about “people who hold cash”. Someone has to hold it. Everyone being a debtor and nobody a creditor… Not here. Not that I know.

Wouldn’t the cost of today’s refrigerator versus the 1970s refrigerator be more of a result from technological and manufacturing advances along with international trade policy? Why not use more frequent and necessary purchases to make your point such as milk, eggs or gasoline (<– yes, it's a challenge).
I strongly disagree with the assumption or deduction that lower interest rates hurt personal savings. What is hurting personal savings is the lack of surplus household revenue and, correct me if I'm wrong, this is due to higher prices which is directly related to inflation against stagnant wages.